A report by Dan Primack for Fortune magazine deduces that private equity firms will be facing tax hurdles regarding monitoring fees. Monitoring fees, as explained in the report, are annual fees paid to private equity firms by acquired firms for management and advisory services. A critic, Primack has argued earlier in a September 2013 report that the monitoring fees are nothing more than a dividend labelled as a service fee.
Primack wrote, "Private equity firms have historically justified these fees by arguing that they are in lieu of their portfolio companies having to pay millions to a third-party consultant, like Boston Consulting Group or McKinsey & Co. What this ignores, however, is that: (a) The monitoring fee arrangements are determined at the time of sale, not at the time of specific consulting need; (b) Private equity firms already are being paid to oversee their investments, in the form of annual management fees paid by their limited partners (which typically are between 1%-2% of committed capital). Imagine any other business where you get paid a salary, but don't show up to work until someone else also pays you to do the same job!"
Both Boston Consulting Group and McKinsey & Co had been criticized for commanding high monitoring fees on its purchased companies.
In his latest report on Fortune, Primack pointed out the tax savings private equity firms gain by simply labeling the payments as fees rather than dividends. For example, he said that private equity firms are allowed to write off the payments they receive from companies as deductible business expenses, as oppose to dividends, wherein a certain tax is levied upon them. He reasoned that when private equity firms decide to divest their companies, the former gain when paying capital gains rates on investment profits. Pointing to a polarizing report by tax professor Gregg Polsky, Primack sided with the argument that the tax treatment was just another revenue scheme by the private equity industry and that the industry has been cheating out the US government in hundreds of millions of dollars due to the mislabel.
In an interview with WSJ, Polsky explained that over Pointing to a polarizing report by tax professor Gregg Polsky from 2008 to 2012 has features that suggested that they should be reclassified as dividends, and therefore should be taxed.
Primack said one could conduct a two-part test to determine whether the monitoring fees are either business expenses or dividends in disguise. He said one of them is that one needs to ask whether such payments are reasonable such that the service performed equates to the payments.
